The Legal Infrastructure of Business

Hedge Funds returns … too good to be true?

Aberrational Performance Inquiry

The hedge fund industry has reached its biggest size in history; hedge funds manage more than $2.2 trillion in assets at the end of the third quarter of 2012. Historically, hedge funds have been exempt by certain registration and reporting requirements and the main reason for this is that only “qualified investors” were allowed to invest in these kinds of funds. In the last years, hedge funds in the US and Europe have been subject to tighter regulation which includes new reporting requirements. Specially in the case of the US, the Dodd-Frank Act now requires that advisers with private pools of capital exceeding US$150 million or more in assets register with the SEC as investment advisors.

In line of this new regulation there has been a new initiative from the SEC called “Aberrational Performance Inquiry” which objective is to combat hedge fund fraud by identifying abnormal investment performance. They use proprietary risk analytics that help them identify potential hedge funds that are consistently outperforming market indexes or achieving positive performance with low volatility.

Yorkville Advisors LLC

Last October the SEC charged the hedge fund advisory firm Yorkville Advisors LLC and two of its executives with scheming to overvalue assets under management and exaggerate the reported returns of hedge funds they managed in order to hide losses and increase the fees collected from investors. They stated that Yorkville has charged at least $10 million in excess fees based on the inflated value of its assets under management.

Yorkville invested in start-up or distressed public companies through securities that were illiquid and only trade over the counter, making the valuation of these securities difficult. Yorkville’s internal policies required it to mark the fund’s investments at fair value and if recent market quotations were not available these securities should still be valued at fair value as determined as good faith by the general partner. However, this last method should only be utilized if independent party valuation could not be obtained in a timely manner.

Nonetheless, the SEC argues that the methodologies Yorkville actually applied to value its convertibles notes in 2008 and 2009 didn’t comport with its valuation policies. For example, Yorkville valued an investment in Levitz Furniture at December 31 of 2008 and 2009 at $17.5 million and $17.3 million respectively although in March 2008 Yorkville has already entered into a settlement in the Levitz bankruptcy to only receive $1.285 million.

Thoughts

This new initiative from the SEC is positive in the sense that it protects investors against potential frauds make by hedge funds or other classes of private pools of capital. The incentives involves in these types of funds, driven by management fees as a percentage of assets under management and performance fees based on the funds results, sometimes generates conflicts of interests between the fund managers and the investors. These conflicts usually arise in the downturns, when managers are under pressure to deliver a good performance. These problems can be exacerbate in scenarios in which funds invests in illiquid assets and there are not market prices to use as reference.

There are four main ways in which inflated valuations can affect investors. First, if management fees are charged based on the value of the assets under management a higher valuation implies higher fees. Second, if the funds receive a performance fee fund managers would be getting overpaid if valuations are inflated. Third, there is wealth transfer from investors who buy interests in the funds at higher false values to investor who sell their positions at those values. Finally, inflated valuations creates a false track record that would mislead future investors.

I believe that the SEC could be able to use its proprietary risks analytics tool to put some funds in its radar screen and pursue further investigations. However, to really charge these funds for some wrong doing would require more objective evidence that they were committing a fraud. Since the SEC has launched this initiative in December of 2011 only seven funds have been charged and in these cases there was clear indications of a potential fraud. The funds would put in its radar those funds whose performance “looks too good to be true”, but they might be some funds that can achieve superior performance or cases in which it could not be possible to determine objectively that valuations are too high.

In this sense, given the possibility of future scrutiny by the SEC, hedge funds should implement some measures to mitigate valuation risks, especially when the assets under management are difficult to value. Some of these measures includes: develop robust and consistent valuation policies and procedures, implement and follow those policies and procedures, and use independent third party valuations. These actions would be very important for hedge funds given that potential inquiries can really damage their reputations and affect negatively their business.

 

http://www.reuters.com/article/2012/10/18/us-hedgefunds-flows-idUSBRE89H0XT20121018

http://www.regulatorycompliance.com/newsletter/2010/April/financial_regulatory_reform.html

http://www.sec.gov/news/press/2011/2011-252.htm

http://www.sec.gov/news/press/2012/2012-209.htm

http://www.sec.gov/litigation/complaints/2012/comp-pr2012-209.pdf

http://seccc.com/news-and-events/newsletter/the-sec-s-continuing-trend-of-identifying-aberrational-performance

http://dealbreaker.com/2012/10/the-sec-is-pretty-sure-its-better-at-investment-valuation-than-at-least-one-hedge-fund/

http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/FinancialAdvisoryServices_FAS/us_fas_sec_increases_scrutiny_of_fund_valuations_061812.pdf

Response to: Chronicle of a Death Foretold – Who Monitors the Monitors?

 

When MF Global filed for bankruptcy protection in August 2011, voices in the media wondered aloud why regulators could not successfully monitor the excessive risk undertaken or why a bailout from the U.S. government wasn’t forthcoming.

A year after MF Global’s bankruptcy, another financial firm, Knight Capital, was near collapse. Though Knight was a broker-dealer much smaller than MF Global and in a different business from MF Global, Knight was the largest handler of stock orders for U.S. retail brokerages. Its case serves as an interesting counterpoint to the bankruptcy of MF Global, as well as the events of the fall of 2008.

What happened to Knight may sound like a scene from a bad movie. Due to a computer glitch, the firm bought $5 billion of stock in a trade that was intended to take place over five weeks but was executed in just 20 minutes. The firm subsequently disclosed a $440 million pretax loss due to this malfunction, while its market value at its low-point after the erroneous trade disclosed was just $250 million. Knight share price plummeted from around $12 in late July 2011 to around $2.50 in mid August of that year.

 

Thus, in a matter of a few minutes, a firm that had been reasonably healthy came close to collapse.

 

To avert bankruptcy, the firm desperately attempted to sell itself to other broker-dealers. These deals fell through, as other firms were reluctant to take on the suddenly-troubled broker-dealer.

Ultimately, Knight secured about $400 million over a weekend from a few investors led by Jefferies. In turn, Knight issued convertible securities, which are bonds that will turn into equity in the firm in the future.

 

The part of the story that is worth highlighting is the tenor of the response within the financial community to Knight’s predicament. While other firms, competitors and clients alike, expectedly based their business decisions in part on the familiar rationale of cost-benefit analysis of the competitive landscape, they also reached out to Knight in attempt to help save the firm.  CEO Thomas Joyce said, in a live interview, "The wildly flattering thing was how our clients responded to us...when we were under stress last week."

It appears that there was willingness on the part of Knight’s counterparties to step in to Knight’s rescue, partly because of the trust that Knight engendered with its business partners over their years of doing business together. While the firm remains a shadow of its former self, its good business relations stood in its good stead and allowed it to stay afloat. Recently, competitors Getco and Viru have offered to buy the company, albeit at $3.50 a share, a fraction of its value in July 2011.

Shareholder lawsuits have come and will be coming in the future against Knight. It should be noted, however, that Knight shares could easily have been wiped out had Knight not been able to secure bridge funding, leaving shareholders without even the fraction of the value of the firm.

 

The point of this episode as it relates to our class discussions of bailouts, bankruptcy, and regulators and accounting firms whose job it is to monitor the business practices of other companies, is that trust built over years of doing business can go a long way into solving unexpected and sometimes difficult problems. Knight CEO Thomas Joyce said that the company received some 90 inquires from clients offering to participate in its bridge funding to avert the firm’s collapse. With 90 market participants offering to chip in, there was little need for the U.S. government to contemplate a bailout even if the government was interested in doing so.

There are of course important caveats to generalizing this episode to the bailouts of 2008 and to MF Global. The most obvious one is the small size of Knight Capital compared to the firms involved in those events. But if professionals and laypeople alike had been told about a trading firm experiencing a bankruptcy-threatening computer malfunction, not many would have predicted an outpouring of goodwill towards Knight from its clients. This goodwill would not have been possible had the U.S. government publicly pondered a bailout.

 

Links:

http://www.forbes.com/sites/halahtouryalai/2012/08/06/knight-avoids-bankruptcy-what-now/

http://www.foxbusiness.com/investing/2012/08/02/investor-psyche-takes-another-blow-with-knight-capital-glitch/

http://online.wsj.com/article/SB10000872396390443866404577566890251463940.html

http://www.foxbusiness.com/industries/2012/08/02/knight-capital-plummets-55-after-disclosing-huge-440m-pretax-loss/

http://www.cnbc.com/id/48516238

http://www.law360.com/articles/370958 

http://www.bloomberg.com/news/2012-11-30/knight-board-said-meeting-next-week-to-study-getco-virtu-offers.html?cmpid=yhoo

 

China's "Shadow Financing" Problem: 2008 Part 2?

Today’s Wall Street Journal has an article that seems like it was planted by someone in our class as it involves our topic of discussion from last night. Specifically, it looks at the problem of “shadow financing” and the problems associated with this industry. Many of the issues China is facing right now are similar to what happened before and during the 2008 collapse of American mortgage backed securities.

Brief History

Shadow financing in China takes place because only 3% of the country’s 42 million small and medium sized businesses are able to get traditional bank loans through China’s state-owned banks. This has led to booming growth in shadow banking, up to its current level of “about a third the current size of the country’s bank-lending market.” These types of loans only made up about 5% of total bank lending in 2008. Many of the shadow loans come from 64 Trust Firms located in major cities across China. These companies operate across many asset classes like “real estate, stocks, bonds, commodities, even bottles of sorghum liquor” by pooling household savings and then making loans and investments. However, trust firms are not the only players. China’s nonbank lenders and its state-owned banks also act as lenders and agents in this system, leading to questions about who is really on the hook when deals go bad.

Similarities to 2008: Too Big to Fail?

The similarities to the 2008 collapse of mortgage-backed securities are numerous. What we have is a situation where firms and banks are soliciting investment tranches to their wealthy clients. In the case of Zhenfu Energy Group, a coal-mine operator owned by Wang Pingyan, China Credit (a nonbank provider of credit) made the loan with the help of China’s largest bank, Industrial & Commercial Bank of China (ICBC). ICBC offered investment opportunities to wealthy customers and collected a fee for doing so. This looks much like the actions of Countrywide when they would originate loans and then sell them off while keeping their origination fee. There are very few regulations around disclosure, and in this case China Credit only issued a prospectus with standard disclosures on risk with no information on Mr. Wang’s business and financing activities. So who’s really liable for the bad debt? The law says that it falls on China Credit, but there is political pressure on ICBC to bear some responsibility “for reputation’s sake and potential social stability reasons.” We’ll need to wait and see who ultimately picks up the tab, but the potential of it falling on the state-own banks is what makes this a societal question.

This case is one example of a systemic problem in China. Many economists argue that tinkering with this type of system now would pose a huge risk to China’s slowing economic growth. Fred Hu, a Beijing-based economist and former greater China chairman at Goldman Sachs Group Inc., went so far as to say “Shadow banking is much vilified, but without it the Chinese economy would have had a hard landing long ago”. I have a hard time disagreeing with him, as the overall shadow-financing market totals about 20 trillion yuan. This is very similar to the government bailouts that were required to save AIG, et al, but it concerns unofficial loans. It will be interesting to see how lawsuits are handled in China regarding investors that got left holding the bag. Is it a case of buyer beware or should more be done to protect investors? This question leads me to see shadow financing as very similar, if not equal, to Crowdfunding.

Does China need a JOBS Act of its own?

China may benefit from trying to regulate these shadow loans much like the Crowdfunding provisions in the JOBS Act attempt to do. It seems like this could go a long way to mitigate some of the risks associated with shadow financing while allowing capital to move where it is needed. So far, there has only been a small pilot program for registering private loans in a city where underground lending is rampant. The success (or lack thereof) of this program will tell us a lot about how receptive the Chinese political climate is to allowing this sort of activity. However, it looks like it is in the country’s best interest to figure out how to accommodate private lenders, as shutting them down completely would pose a huge risk of bringing the economy to its knees.

Sources:

http://online.wsj.com/article/SB10001424127887324712504578133053914208788.html?mod=ITP_moneyandinvesting_0

http://www.bloomberg.com/news/2012-11-19/purple-palace-abandoned-shows-china-shadow-banking-risk.html

http://www.bloomberg.com/news/2012-07-16/china-slowdown-stymies-plan-to-curb-shadow-banking-risks.html

http://www.fcpablog.com/blog/2012/7/13/chinas-shadow-economy-threatens-stability.html#

In response to: "Rating Agencies Just an Opinion", --Next Risks and Challenges--

This post is a reply to Andrew’s post and Karishma’s reply over the recent ruling by the Australian Curt that found Standard & Poor’s ratings to be “misleading and deceptive” for investors in a certain credit derivative product. This is a very controversial case that has been classified as a “landmark” for the future by some journals.

The Federal Court of Australia ordered that S&P, ABN Amro Bank and Local Government Financial Services (LFGS) combine to pay $15 million Australian dollars ($15.3 US dollars) to 13 Australian municipalities, plus legal costs and interests. This was a result of the lost in the financial crisis of 2008 of over 90% of the face value of the derivatives rated triple-A by S&P and purchased by these municipalities in 2006.

Controversy

Just as many people, I agree that credit agencies must be liable and fined if they fail on their functions of providing a “competent” rating analysis. If S&P failed to performed a deep and reasonable analysis over those complex credit derivatives (CPDOs), or did not fully understood the product and its risks to adequately assign a rating, then it should be held liable of its actions just as any other companies and individuals are liable and fined for their “incompetent” actions as they perform their profession or duties. Doctors, accountants or engineers are sued every day regarding “incompetent” actions in their profession, and have to manage those legal risks carefully.

Thus, this case certainly holds the big risk of being wrongly interpreted in the future and resulting in a sue to the credit rating each time a triple-A security defaults. A triple-A rating does not assure that any financial instrument would no default under any circumstance. These instruments could clearly default at
any time under the worst-case scenario, out of the statistical scope of an analysis. Thus, what this rating means is that their likelihood of default (encompassing both capacity and willingness to pay) is “statistically very low”.

Standard & Poor’s defines the securities rated in the highest categories as having the ability to withstand extreme or severe stress in absolute terms without defaulting. Specifically, S&P under its “General Criteria” document gives the Great Depression as an example of the scenario applied for a triple-A rating. S&P specifies that: “the issuer or obligation rated “AAA” should be able to withstand an extreme level of stress and meet its financial obligations in such a scenario as the Great Depression with a real GDP decline of 26.55%... unemployment peaking at 24.9%, production decline by 47% and stock market dropped by 85%...” Other scenarios such as the panic of 1857 are also used as an example by S&P.

 

Thus, there are clearly many other scenarios that could happen such as the 2008 Financial Crisis that resulted in even more adverse conditions in some metrics than the Great Depression, and there is no assurance that a triple-A security would resist that. S&P includes this in its disclosure, appealing to the First Amendment Act of the U.S.

Next Challenges and Risks for Credit Agencies

The risk is that as soon as any other triple-A rating defaults, we could expect sues holding the rating agencies liable for this case. But the court would need to understand that there is no wrongdoing or incompetence in rating the defaulted security as triple-A, but only in not performing an “adequate analysis” to get to that rating, given that that is the profession or responsibility of the rating
agency.

What would be the next challenge for the courts in Australia and probably in other countries would be to qualify the performed analysis as “adequate” or as “competent” given their low expertise in rating analyses. We would need to believe that the court judgment over this qualification is in fact more accurate than what the rating agency decided as relevant or important for its assessment. Qualifying
an analysis as “incompetent” and thus imposing a penalty over the rating agencies will definitively be a challenge for the legal system. Thus, there is no doubt that S&P and the other rating agencies will need not only to perfectly document each analysis and stress scenario for each credit rating as to prove a
competent analysis in each case, but also, to include an additional spread in their pricing as to include a higher probability of being fined in a case of litigation of a defaulted security. The result will certainly be in less triple-A rated securities in the system.

Sources

 http://picker.typepad.com/legalinfrastructure/2012/11/rating-agencies-just-an-opinion.html

http://www.standardandpoors.com/prot/ratings/articles/en/us/articleType=HTML&assetID=1245319385017

http://picker.typepad.com/legalinfrastructure/2012/11/in-response-to-rating-agencies-just-anopinion.html

http://www.dw.de/ratings-agency-sp-loses-landmark-case/a-16357204

 

Author: Amadeo Ibarra

In response to: “Rosetta Stone vs. Google”

After reading the post Rosetta Stone vs. Google, I became curious about how eBay has dealt with similar issues in the past.  As I am sure you’re aware, eBay’s website allows any seller to list an item for auction.  eBay doesn’t perform any diligence on the item (as to authenticity) and simply relies on a buyer feedback system to presumably weed out any sellers who provide poor products (counterfeit goods would fall into this category).  [Note: after more research, I learned that eBay does actively try to prevent counterfiet sellers, but I don't think this is widely known amongst non-eBay users.]

Having this basic knowledge about eBay’s business model seems to draw some clear comparisons to Google, who is essentially earning a fee in a similar way without any regard to the legitimacy of the item or any trademark violation (while acknowledging there is a slight difference because Google doesn’t earn a fee on the sale but rather the mouse click).

The most prominent case in the U.S.  appears to be Tiffany Inc. v. eBay, Inc.  The 2004 lawsuit sued eBay for trademark infringement, trademark dilution, and false advertising.  The claims were based in part on surveys that Tiffany conducted as part of their case.  Tiffany’s surveys found that the vast majority of goods on eBay were counterfeits.  The results were truly staggering.  The independent survey used the search terms “Tiffany” and “sterling” and bought a sample of the items.  Of the tested items, 73% were counterfeit, 5% were authentic, and the remaining 22% were unverifiable.   These results indicate that the unmonitored auction market place was providing eBay with a healthy profit on counterfeit goods.

When the court addressed the 2004 lawsuit, it ruled in favor of eBay on all claims.  Its findings were based on several facts, most notably that (i) eBay promptly removed listings that it believed to be in violation of laws and its terms and conditions; (ii) the trademark holder has the responsibility to police infringement (not eBay); and (iii) eBay was not willfully blind of the infringement and had programs to address infringement.

Despite the ruling in the U.S., there have been other jurisdictions that have not been so favorable to eBay.  For instance, LVMH Moët Hennessy Louis Vuitton sued eBay in French court in 2006.  LVMH alleged that 90% percent of Louis Vuitton bags and Dior perfumes sold on eBay are fraudulent.  The French court ruled in 2008 that eBay should pay 38.6 million euros because it did not do enough to prevent the sale of fraudulent goods.  After a number of appeals, the fine was cut down to 5 million euros.  The court further clarified that the French courts could only rule on their home-country version of the eBay website – saying that French courts had no ability to block sales of LVMH goods on the American site ebay.com.

From eBay’s perspective these lawsuits are not about counterfeit goods, but restricting competition.  Luxury goods makers do not want their image tarnished by having authentic used merchandise sold at a discount on auction web sites.  eBay argues that the new policies that it has implemented are effective to address the concerns of the manufactures.

If one does really agree that the case is about counterfeit goods, it seems to really be about who should pay for the cost of enforcement.  It seems like the US is relatively clear on this, but other jurisdictions might not come to the same conclusion.

On the basis of what I’ve learned about eBay, it seems logical to me that Google should try to reasonably remove vendors that are advertising counterfeit goods.  Google can probably do this on a cost effective basis, while the trademark holder retains the responsibility to police infringement.  They should notify Google when a fraudulent seller is advertising through Google and Google should lock the account of the counterfeiter.

However it turns out there is a practical lesson for anyone looking for a deal – buyer beware.

Sources:

http://picker.typepad.com/legalinfrastructure/2012/11/rosetta-stone-vs-google.html

http://www.nytimes.com/2008/07/01/technology/01ebay.html

http://en.wikipedia.org/wiki/Tiffany_Inc._v._eBay,_Inc.

http://www.nytimes.com/2008/07/01/technology/01ebay.html?_r=0

http://online.wsj.com/article/SB10001424052702304743704577382204111836554.html

http://www.cnn.com/2008/BUSINESS/06/30/louis.vuitton/

 

Solyndra Bankruptcy Ruling

The U.S. Bankruptcy Court in Wilmington, Delaware, ruled in favor of a reorganization plan for Solyndra, the failed manufacturer of solar panels, last week. Solyndra has made headlines after receiving $535 million in government loans funded by President Obama's economic stimulus plan. The company entered bankruptcy amid low cost competition from Chicago, combined with falling materials costs used by the foreign competition. According to the chairman of the House Oversight and Government Affairs Committee, combined US government losses should now surpass this original loan and could reach as high as $850 million. 

Solyndra generated approximately $117 million from asset sales, including the proposed sale of its former manufacturing plant to Seagate. The company expects to have roughly $71 million in distributable assets after transaction expenses. Holders of the remaning $186 million in secured debt, which is subordinate to the government’s claims, are expected to receive no payment.

The ruling may be appealed by the US government because Solyndra's parent company, 360 Degree Solar Holdings, was allowed to retain an estimated $875 - $975 million in net operating losses that may be used as tax write-offs against future earnings. These future tax savings for investors, after large government losses, led the DOE and IRS to oppose this plan. 

"DOE is expected to recover a minimal amount on its initial $535 million loan, while the Internal Revenue Service (IRS) warns that the government may be out up to another $341 million due to Argonaut-Mardone's tax write offs," the committee chairman wrote. The IRS has claimed the primary purpose for the Chapter 11 filing was tax avoidance. Solyndra had a 73% debt to value ratio when entering bankruptcy. This is well below the target capital structure that the DOE prefers. 

The reorganization plan has only the parent (holding) corporation emerging from the bankruptcy process. All other assets are in the process of or will be liquidated. The single emerging entity will neither sell products nor have employees, but will emerge with the Solyndra tax offsets intact. Creditors will receive a fraction of their princpal while equity holders walk away with over $341 million in potential tax savings. Under the bankruptcy plan, taxpayers will recoup only $27 million on the $535 million loan. Should the court separate the equity holders from these valuable tax assets? They could order the sale of this holding corporation and then allow this payment to go to creditors with a higher priority in the liquidation process. Change in ownership currently impacts the value of the NOLs and may leave to the loss of all of these tax benefits or force them to be recognized over an extended time period. Granted the equity holders will only derive value from this tax assets should be able to generate future profits. UCC 9-609 states that secured creditors have the right to repossess collateral after default, but it's unclear how these tax assets could be included as collateral. 

A House Energy and Commerce Committee early this year said the Energy Department violated the bankruptcy code by subordinating its claims to those of the private investors. The largest investor in question is George Kaiser, a Tulsa oil billionaire. Kaiser has gained attention because he was a large Obama campaign supporter in 2008 and 2012. These investors have already begun searching for businesses to invest in with these tax assets. 

 

Sources:

http://www.bloomberg.com/news/2012-10-22/solyndra-wins-court-approval-of-bankruptcy-exit-plan.html

http://www.huffingtonpost.com/2012/11/15/solyndra-headquarters-sale_n_2138413.html

http://www.washingtontimes.com/news/2012/nov/21/solyndra-lawyers-reap-green-but-not-energy/?utm_source=RSS_Feed&utm_medium=RSS

http://www.thenewamerican.com/tech/energy/item/13444-obama-fundraiser-is-winner-in-solyndra-bankruptcy-ruling

http://online.wsj.com/article/SB10000872396390444799904578050803545600588.html